Q+A-Sri Lanka IMF loan delay and parliamentary election

Sri Lanka will initiate economic reforms in its next budget following a parliamentary election in April, after the IMF delayed a tranche of a $2.6 billion loan to add pressure on the government to rein in a budget deficit. [ID:SGE6220HA]

Here are some questions and answers on the implications of the IMF delay, announced late last month:

WHY DID THE IMF DELAY THE LOAN?

The IMF had approved the loan in a 20-month programme aiming for prudent fiscal management with certain quarterly targets after identifying Sri Lanka’s high deficit as a major weakness. Achieving the targets was required to get the loan payments in a scheduled eight tranches.

However, Sri Lanka failed to achieve its December quarter budget deficit target of reducing the end-2009 deficit to 7 percent of GDP. The deficit instead stood at 9.7 percent.

IS POLITICS BEHIND THE MISSED TARGET?

Though the global economic crisis had a significant impact on Sri Lanka’s 2009 revenue, political analysts say President Mahinda Rajapaksa’s government worsened the situation, and thus the deficit, in the fourth quarter by a populist tax-cutting policy ahead of January’s presidential poll, where Rajapaksa was reelected.

There was also an increase in government expenditure due to high wage bills for a bloated public sector, which analysts say boosted the ruling party’s vote base. Sri Lanka has a public sector of around 6 percent of the population.

Maintaining loss-making public institutions without reforms, high and unproductive subsidies, a government with over 110 ministers, and expenditures that make more political than economic sense are other factors in the deficit.

However, high spending also reflected the postwar rehabilitation and welfare costs for over 300,000 people displaced during the war between the government and Tamil Tiger insurgents, which ended with a government victory last year.

WILL THERE BE ANY INVESTMENT IMPACT?

The IMF delay is expected to have an adverse impact on sentiment of foreign investors, closely monitoring Sri Lanka as a "frontier economy" since the end of the war. Analysts say many investors will take a wait-and-see approach until they are sure about a degree of political and economic stability under relatively prudent fiscal management.

Suspension of the IMF loan by either party could lead to rating downgrades, volatility in macroeconomic fundamentals, withdrawal of foreign funds from government securities, and increased borrowing cost for a planned 10-year, $500 million sovereign bond later this year.

WHAT IS THE OUTLOOK FOR GETTING THE LOAN BACK ON TRACK?

Sources close to the IMF have told Reuters privately that the global lender will delay the third tranche until it sees signs of improvements in the country’s fiscal management.

If Rajapaksa, after the election, could implement reforms in taxes and public sector spending and efficiency, that could translate into deficit reductions satisfying the IMF.